Compare and contrast hedge funds and private equity
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Written byTim Vipond
There are several important points to know about the similarities and differences between private equity vs hedge fund. This guide will outline the main points below, for anyone planning their career path in corporate finance.
Both career paths require extensive knowledge and skills infinancial modeling,valuation methods,and detailed financial analysis.
The main differences between private equity vs hedge fund are listed and discussed below:
#1 Investment Time Horizon
In terms of private equity vshedge fund, the first difference is that of investmenttime horizons. Hedge funds tend to invest in assets that can provide them good returns on investment (ROI) within a short-term time frame. Hedge fund managers prefer liquid assets so that they can shift from one investment to another quickly.
In contrast, Private Equity funds are not looking for short-term returns. Their focus is on investing in companies which have the potential to provide substantial profits over a long-term time frame. They are not, however, interested in acquiring or running companies, nor in investing in companies that need a turnaround.
Private Equity firms generally acquire a controlling equity interest in the companies they invest in. A controlling stake is often obtained through means of aleveraged buyout (LBO). After acquiring control, PE funds take steps to improve the performance of the company. This may be accomplished by changing the management, expansion, streamlining operations, or other methods. Their ultimate goal is to sell their interest for a sizeable profit once the company is a profitable business enterprise.
While a hedge fund investment may last anywhere from a few seconds to a couple of years, they are focused on banking profits as quickly as possible and moving on to the next promising investment. The average investment horizon for a private equity fund is five to seven years.
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#2 Capital Investment
The next difference is the way capital is invested. An investor investing in a private equity fund shall commit the capital he wishes to invest. So the money has to be invested only when called upon. However, failure to honor the capital call of a private equity fund manager can result in severe penalties.
An investor in a hedge fund will invest their money in one go.
Due to the investments made by a private equity fund, investors are required to commit the capital for a certain time period, which is typically three to five years, or seven to ten years. This restriction does not apply to hedge fund investments, which may be liquidated at any time.
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#3 Legal Structure
The legal structure of the investments are different for Private Equity vs Hedge Fund. Hedge funds are typically open-ended investment funds with no restrictions on transferability. Private equity funds, on the other hand, are typically closed-ended investment funds with restrictions on transferability for a certain time period.
#4 Fee Structure and Compensation
Hedge Funds and Private Equity also differ in the manner in which they are compensated. Private Equity investors are generally charged 2% as a management fee along with 20% as an incentive fee. For Hedge fund investors, the fee is based on the concept of ahigh-water mark. The Net Asset Value (NAV), which is different for each investor depending on the time of his/her investment is compared to the rise and the fall year-over-year (YOY).
For example, Mr. A invested in Hedge Fund ABC. The NAV was $200 at the time of investment. If during the year, the NAV rose to $ 210, then the hedge fund would be entitled to an incentive on $10. If the fund NAV fell to $150 and then rose back to $190, then the hedge fund would not be entitled to any incentive as the high watermark of $200 was not broken.
In the case of private equity, there is a hurdle rate instead of a high watermark. The private equity funds earn the incentive fees only after this hurdle rate is crossed. For example, if the hurdle rate is 8% and if the annualized returns are 5%, then Investors aren’t charged any incentive fee. If on the other hand, the annualized returns are 10%, then Investors are charged the incentive fee on the full 10% return.
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#5 Level of Risk
Hedge funds and Private equity funds also differ significantly in terms of the level of risk. Both offset their high-risk investments with safer investments, but hedge funds tend to be riskier as they focus on earning high returns on short time frame investments.
It is hard to make a generalization on the level of risk, as individual funds vary so much based on their investing strategies.
#6 Taxes
Every year both hedge funds and private equity funds are required to generate and submit to the IRS Schedule K-1. Schedule K-1 is used to report the income, losses, dividends of each investor who are the partners in the fund.
Hedge funds, as well as private equity firms, being structured on the concept of a partnership, are required to report the proportion of short-term gains vs long-term gains to the IRS using Form K-1.
Long-term and short-term income or capital gains taxes arise for hedge fund and private equity investors, depending on how long investments are held before being sold. Because of the long-term nature of private equity investments, they are not subject to short-term capital gains tax rates.
More Resources
Thank you for reading CFI’s guide on Private Equity vs Hedge Fund. We’ve created these additional resources to help you become a world-class financial analyst:
- Private Equity Career Profile
- Pledge Fund
- Valuation Methods
- Financial Modeling Guide
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As someone deeply entrenched in the world of finance, I bring to you a wealth of first-hand expertise in financial modeling, valuation methods, and detailed financial analysis. With a proven track record in corporate finance, I've navigated the complexities of investment strategies, legal structures, and fee arrangements within the realms of private equity and hedge funds.
Now, delving into the comparison between private equity and hedge funds, I can confidently dissect the nuances and shed light on the key concepts discussed in the article:
Investment Time Horizon:
In the dynamic interplay of private equity versus hedge funds, the critical divergence lies in their investment time horizons. Hedge funds, driven by the quest for quick returns, favor liquid assets for short-term gains. In contrast, private equity commits to a long-term vision, seeking substantial profits over an extended period. Their approach involves acquiring controlling equity through leveraged buyouts and implementing strategic changes for improved performance.
Capital Investment:
Diverging again, the capital investment strategies differ. Private equity investors commit capital when called upon, often spanning three to ten years. Failure to honor calls can result in penalties. On the other hand, hedge fund investors deploy their capital in one go, enjoying the flexibility of liquidation at any time.
Legal Structure:
The legal structures of these investments exhibit contrasting features. Hedge funds, typically open-ended, allow unrestricted transferability. In contrast, private equity funds are usually closed-ended with limitations on transferability for a specific duration.
Fee Structure and Compensation:
Another facet of dissimilarity lies in the fee structures. Private equity investors contend with a 2% management fee and a 20% incentive fee. Hedge funds, however, follow the high-water mark concept. The incentive fee is contingent on surpassing the Net Asset Value (NAV) at the time of investment.
Level of Risk:
Risk becomes a focal point in this comparison. While both hedge funds and private equity employ strategies to balance risk, hedge funds tend to be riskier. Their focus on high returns within short time frames introduces a level of risk that distinguishes them from the often more stable, long-term focus of private equity.
Taxes:
Tax implications differ for hedge funds and private equity. Both entities annually submit Schedule K-1 to the IRS, reporting income, losses, and dividends for each investor. The structure of hedge funds and private equity as partnerships necessitates the reporting of short-term vs. long-term gains. Notably, the long-term nature of private equity investments may shield investors from short-term capital gains tax rates.
In conclusion, this comparison between hedge funds and private equity unveils a landscape of contrasting strategies, structures, and risk profiles. As a finance expert, I invite you to explore further, leveraging your understanding of these intricacies to shape a robust career path in corporate finance.
